Index

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An index is a method of measuring the value of a section of a capital market, such as stocks and bonds. It is computed from the prices of selected marketable securities of the given market, market segment or asset class.

The value of an index is calculated on a regular basis using either the actual or estimated market prices of the individual securities, known as constituent securities, within the index.

Indexes are used to gauge market sentiment, benchmarks for actively managed portfolios and the underlying portfolios for investment products such as index funds and exchange-traded funds (ETFs).

Types of indexes

As the name suggests, a price return index, also known as a price index, reflects only the prices of the constituent securities within the index. A total return index, in contrast, reflects not only the prices of the constituent securities, but also the reinvestment of all income received since inception.[1] It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.

Index methodologies

All the major market indexes have been developed by long-established, well-respected providers. Investors generally assume that these indexes are equally fair, relevant, and accurate representations of market performance.[2]

Index providers make choices when creating an index. These choices typically include:[1]

  • the target market to represent
  • which securities should be selected
  • how much weight should be allocated to each security. Choices include equal weighted, fundamentally weighted, market capitalization weighted, or price weighted.
  • when should the index be rebalanced
  • when should the security selection and weighting decision be reviewed

Weighting methodologies

The most common weighting methodology for equity markets is market capitalization weighted.[2]

Market capitalization weighted

In a market capitalization weighted index, securities are held in proportion to their value (market capitalization).

Large, mid and small caps

In general, the stock market of each country is composed of three levels of market capitalization: large, mid and small. Indexes are generally available for each segment. An example of a large-cap index for US Equities is the S&P500.

Total market index

A total stock market index, sometimes known as an 'all-cap' index, attemps to capture the entire stock market of a country. Such indexes will have minimal turnover and are becoming more popular among ETF providers (e.g., [3][4]) and investors.

Other weighting methods

Equal weighted

An equal weighted index is simple but results in under- and over-representation and requires frequent rebalancing.[1]

Fundamentally weight

A fundamentally weighted index is based on screening for specific fundamentals as specified by the index provider. It results in an index that is data intensive and that provides a value or contrarian tilt.[1]

Price weighted

A price weighted index is also a simple index. However high price stocks have a greater impact and stock splits result in arbitrary changes to the index.[1]

Equity indices

The following indices are market capitalization weighted unless otherwise noted. They are highlighted given their relevance for Canadian investors.

Canadian indices

The S&P/TSX Composite Index[5] is an index of the stock (equity) prices of the largest companies on the Toronto Stock Exchange (TSX) as measured by market capitalization. It "covers approximately 95% of the Canadian equities market"; at the end of 2014 it had 250 constituents and the top-ten companies made up 36% of the index. [5] It is the headline index for the Canadian equity market and the broadest available Canadian index. It replaced the earlier TSE 300 index. Most index funds and ETFs track the capped version (where each company is capped to a 10% weight), but at the end of 2014 no constituent made up more than 6%.

The S&P/TSX 60 Index[6] is a stock market index of 60 large companies listed on the TSX.

A lesser-known index is the FTSE Canada All Cap Index, with 245 constituents, covering Canadian large, mid and small cap stocks [7]. Based on their yearly total returns over the period 2005-2014, the FTSE Canada All Cap Index and the S&P/TSX Capped Composite Index are perfectly correlated (coefficient of correlation of 0.999) and have the same annualized return (7.6%), as shown in the following graph:

TSX-Comp-FTSE.jpg

US indices

See also: US Equities

The well known US indices are the S&P 500[8] and the Dow Jones Industrial Average (also known as the Dow, or the Dow 30). The Dow Jones Industrial Average is not a market capitalization weighted index.[9] and includes only 30 companies. The S&P500 is a more representative large-cap index containing 500 companies which, according to S&P, "captures approximately 80% coverage of available market capitalization". At the end of 2014 the top-ten constituents made up 18% of the index.[8] The S&P500 is the benchmark for US equity funds in Canada, and numerous index funds and ETFs track this. Total market indexes for US equities are presented on the Bogleheads wiki.

International indices

The MSCI EAFE (Europe, Australasia, Far East) index is a widely used index for developed market equities from countries outside of North America. In Canada the Canadian dollar version of the EAFE index is the typical benchmark for international equity funds. Several ETFs offered on the TSX and US exchanges explicitly seek to track the EAFE index. According to MSCI, at the end of 2014 the EAFE index had 910 constituents and covered "approximately 85% of the free float-adjusted market capitalization in each country", i.e small-cap stocks are not represented. [10] At this date, the top-five countries in the index were Japan, the UK, France, Switzerland and Germany. The top-ten constituents made up only 13% of the index.

Emerging market indices

Dow Jones, FTSE, Morningstar, MSCI, Russell, and S&P now provide emerging market indexes. Country representation varies among providers. The variation in index composition results in a dispersion of index returns. The MSCI Emerging Markets Index seems to be the most popular basis for indexed products in Canada. At the end of 2014, it had 834 constituents covering 85% of the market capitalization in 23 countries; the top-five countries were China (22%), South Korea (15%), Taiwan (13%), Brazil (9%) and South Africa (8%); and the top-ten companies made up 18% of the index.[11]

All-World ex-Canada

The FTSE All-World ex Canada Index[12] covers the entire world except Canada, including developed and emerging markets. At the end of 2014 the index had 2951 consituents; the US represented 53%, Japan 8%, the UK 7%, France, Germany and Switzerland each 3%; and the top-ten companies represented 9%. [12]

An index with a similar mandate is the MSCI ACWI ex Canada IMI Index.[13]

Fixed income indices

Canadian bond indices

FTSE TMX Global Debt Capital Markets (formerly PC-Bond / DEX) is the predominant provider of fixed income indices in Canada. It is best known for the Universe Bond Index.[14] The Canada Universe Bond index consisted of 1303 investment-grade securities as of April 2014. [15] The Universe Bond Index bond index is compared with a global bond index in terms of maturities, credit ratings and issuers below.

Well-known sub-indices of the Universe Bond Index include:

  • Short Term Bond Index, one to five years.
  • Mid Term Bond Index, five to ten years.
  • Long Term Bond Index, 10+ years.

Global bond indices

Two bond indexes used by ETFs trading on the TSX are:

  • The Barclays U.S. Aggregate Float Adjusted Bond Index (CAD Hedged) is "a market-capitalization-weighted index that represents a wide spectrum of public, investment-grade, taxable, fixed income securities in the U.S.—including government, corporate and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities—all with maturities of more than one year, with the U.S. dollar exposure of the securities included in the Barclays U.S. Aggregate Float Adjusted Bond Index hedged to the Canadian dollar." [16] The index includes over 9000 bonds, with an average duration of about 6 years.
  • The Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (CAD Hedged) is "a market-capitalization-weighted index that represents a wide spectrum of the global investment-grade, fixed rate, and fixed income markets outside the U.S. - all with maturities of more than one year-with the foreign currency exposure of the securities included in the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index hedged to the Canadian dollar."[17] The index includes over 8000 issues and has an average duration of about 7 years. Europe represents over 55% and Japan is over 20%. Canada is about 5%.

Canadian vs. global bonds

The following table compares the Canada Universe Bond index with a global ex-US bond index (based on an ETFs that tracks them, since the information is not forthcoming on the index providers' websites). This shows that the Canadian bond market is well diversified by term (short, medium, long) and credit rating. The higher proportion of AAA issues in the Canadian index is due to the federal government rating.

Canada[18] Global ex-US[19]
Credit ratings
AAA 42% 24%
AA 23% 25%
A 24% 32%
BBB 9% 19%
Junk 0% 0%
Maturities
<1 year 0% 1%
1-5 years 39% 41%
5-10 years 26% 32%
>10 years 34% 26%
Weighted ave 10.5 years 8.8 years
Duration 7.6 years 7.2 years
Issuers
Federal govt 35% ?
Provinces 32% ?
Municipalities 2% ?
Corporate 27% 16%[20]
Other 4% ?

See also

References

  1. 1.0 1.1 1.2 1.3 1.4 CFA Institute, Chapter 2 Security Market Indices (Powerpoint presentation - undated), viewed January 21, 2015.
  2. 2.0 2.1 Determining the appropriate benchmark: A review of major market indexes, Vanguard research, April 2010. Viewed January 22, 2015.
  3. Canadian Couch Potato, New iShares ETFs Give Canadians the World, April 13, 2013, viewed December 30, 2015
  4. Canadian Couch Potato, Vanguard’s VXC Gets a Facelift, June 16, 2015, viewed December 30, 2015
  5. 5.0 5.1 S&P/TSX Composite (CAD) - S&P Dow Jones Indices, viewed January 21, 2015.
  6. S&P/TSX 60 - S&P Dow Jones Indices, viewed February 28, 2014.
  7. FTSE, FTSE Canada All Cap Index, viewed January 21, 2015
  8. 8.0 8.1 S&P 500® - S&P Dow Jones Indices, viewed January 21, 2015.
  9. Dow Jones Industrial Average Overview, S&P Dow Jones Indices LLC, viewed January 21, 2015.
  10. MSCI, MSCI EAFE Index (CAD), viewed January 21, 2015
  11. MSCI, MSCI Emerging Markets Index (CAD), viewed January 23, 2015
  12. 12.0 12.1 FTSE, FTSE All-World ex Canada Index (CAD), viewed January 21, 2015
  13. MSCI, MSCI ACWI ex Canada IMI Index, viewed December 30, 2015
  14. FTSE TMX Canada Indices, viewed December 17, 2014.
  15. FTSE, Ground rules for the FTSE TMX Canada Universe Bond index series, viewed January 24, 2015
  16. U.S. Aggregate Bond Index ETF (CAD-hedged) (VBU)
  17. Global ex-U.S. Aggregate Bond Index ETF (CAD-hedged) (VBG)
  18. Data from XBB (iShares Canadian Universe Bond Index ETF), 29 January 2015
  19. Data from VBG (Vanguard Global ex-U.S. Aggregate Bond Index), 31 December 2014
  20. Standish, The case for global fixed income investing, Fall 2014, viewed February 1, 2015

External links